Coffee Break 1/21/2019

LAST WEEK IN A NUTSHELL

The UK parliament rejected the withdrawal deal Theresa May negotiated with the European Union, triggering a confidence vote that the government survived.

In spite of the current context of slowing global growth, the Q4 2018 corporate earnings season has started on a positive note, boosted by supportive outlook from major banks.

The partial US government shutdown is still pending, leaving ca. 800,000 civil servants without pay and slowing SEC approvals.

In the euro zone, Germany’s 2018 GDP grew by 1.5% compared to 2.2% in 2017, and narrowly escaped a recession in H2.

WHAT’S NEXT?

A revised “Brexit” deal must be presented to the UK Parliament’s members.

The annual World Economic Forum in Davos will gather the world’s top brass (Germany's Merkel, Japan's Abe, Brazil's Bolsonaro, Italy's Conte or South Africa's Ramaphosa) but neither Theresa May nor Donald Trump or Emmanuel Macron will attend.

PMI flash readings will be published for the euro zone and the US. They are expected to confirm that the current expansion is slowing but still continuing.

The ECB will hold its first post-QE press conference. It remains to be seen if it adopts a more dovish forward guidance and also emphasises on patience and flexibility.

INVESTMENT CONVICTIONS

Core scenario

In Emerging economies, activity has continued to soften. In Asia in particular, unintended inventories have piled up and this will continue to be a drag on industrial production.

In China, the downswing is not over: exports and industrial activity will stay weak for a while. But authorities’ measures to support the economy should in the end allow the GDP growth to be on average around 6% in 2019. We note that the announced measures will imply more efforts in the future to put public debt on a sustainable path.

In the US, we expect growth to continue, albeit at a slower pace (2.4% on average in 2019 vs. 3% in 2018). The fiscal stimulus is fading and uncertainties related to trade are lingering but business activity has been rather resilient and consumption is supported by a tight labour market. The Fed will stay pragmatic (“data dependent”) to ensure a soft landing. We expect two hikes in 2019.

In Europe, the economic cycle is less dynamic (on average over 2019, GDP growth is expected to be at 1.4%). Policy risks persist. “Brexit” uncertainty in particular will not fade quickly. Given the current high level of inventories, this will have a negative impact on UK activity in the coming quarters. In the euro area, some temporary factors have depressed activity since last summer but lower oil prices and looser fiscal policies should however help the region steer clear from a recession.

Market views

The world economy is slowing, but still growing. The various political risks are a headwind.

Expectations of slower earnings growth in 2019 are now widespread.

Valuations have come down sharply in 2018. Most of the de-rating is likely behind us.

If political risk recedes, there is a strong potential for a re-rating.

Risks

Trade war: Higher tariffs and protectionism are slowing down global economies, deteriorate international relations and ultimately corporate margins. China and the US have agreed on a short-term truce in this trade war. As the US wants to stay ahead of the game, especially in the Tech sector, the trade war is unlikely to evaporate quickly.

Emerging markets slowdown: Emerging markets are among the most vulnerable regions when global growth slows down. Any fiscal or monetary measures taken to mitigate the impact of the trade war will weigh on their budget.

EU political risks: Political pitfalls could fuel euro scepticism further as opinions diverge on a growing number of issues, i.e. “Brexit”, Italian public finances and social unrest in France and with EU Parliament elections across Europe this May. For now, the trade war initiated by the US has only impacted the euro zone indirectly.

Domestic US politics: A divided Congress, not to mention the current government shutdown, the forthcoming budget-related deadlines and dimming global growth prospects will weigh on US exports while the Fed normalisation is already affecting residential investments.

RECENT ACTIONS IN THE ASSET ALLOCATION STRATEGY

We remain moderately overweight equities as we expect, in today’s environment and for 2019, a moderate equity market rise. From a regional perspective, we remain overweight US and euro zone equities. We continue to hold a negative view on the UK, due to the unresolved “Brexit” issues, while being neutral emerging markets and Japan. In the bond part, we keep a short duration. Our fixed income preference goes to Emerging markets and we recently added some US High Yield exposure.

CROSS ASSET VIEWS AND PORTFOLIO POSITIONING

We have kept our equity exposure overweight and still have a constructive medium-term view.

We are overweight US equities. Economic momentum faded but remains positive. We expect slower, but rising, earnings growth in 2019. The slowdown underway is likely to moderate the Fed’s hawkishness as it is “data dependent”.

We remain overweight euro zone equities. Slow growth and political uncertainties have increasingly been weighing on the stock market. Conversely, any conflict resolution is a potential trigger for a strong rebound.

We are neutral Japanese equities. Japanese stocks reflect less domestic risk as “Abenomics” will continue for three more years. The cyclical economic momentum is becoming less favourable.

We are tactically neutral emerging markets equities. While we believe in the growth of Emerging markets, they are badly hit by the trade war and the developed markets’ slowing growth.

We are underweight bonds and keep a short duration

We expect rates and bond yields to rise gradually after the strong decline in recent weeks. In addition to rising producer prices, rising wages and trade tariffs could push inflation higher.

An expanding European economy could also lead EMU yields higher over the medium term. We expect interest rates to gradually increase. We remain underweight Italian bonds. The ECB remains accommodative, but has ended its QE in December.

The interest-rate differentialbetween the US and Europe will remain high but should gradually reduce, on the long part of the curve, to begin with.

We have a cautious medium term view on corporate bonds overall but we see tactical opportunities in this asset class, in particular on US High yield.

Emerging market debt faces headwinds with trade war rhetoric and rising US rates, but we believe spreads can tighten from current levels. The carry is among the highest in the fixed income universe. It represents an attractive diversification vs other asset classes.